Capital Employed is the total amount of investment made for running the business. It should not be confused with the term “capital.” Capital represents funds contributed by the owner (s) in a business, whereas the former has a wider meaning. It includes funds from both the owners and lenders, i.e., it covers both equity and debt.
There is no universal definition of the term capital employed. However, the general intuition is that it is the investment in a business for earning profits. In one sense, it reflects the total funds put to use (i.e., employed) for running the show. In other words, it is the value of assets that provide the business with its ability to earn revenues. More technically, it is the amount of capital we use to acquire profits or assets.
Computation of Capital Employed
Different accountants compute it differently. Capital employed can be computed using either the asset side or the liabilities side of the balance sheet. To get a better understanding, let us see the examples below :
Using the Asset Side of the Balance Sheet
In this method, we include:
- All the fixed assets are at their net values after accounting for depreciation. In an inflationary scenario, the replacement cost of these assets should be used as it reflects their current market value better.
- All investments made in the business.
- All current assets viz. sundry debtors, cash, bank, bills receivable, stock, etc.
Importantly, it considers business assets only. That means although we do take into account intangible assets like goodwill, patents, and trademarks, we do not take fictitious assets into account.
Finally, current liabilities are subtracted from the above.
For a quick calculation, refer to Capital Employed Calculator
Let us make our concepts concrete with an example. Consider the following balance sheet:
|I. Equity and Liabilities|
|1. Shareholder’s Funds|
|a) Share Capital||400000|
|b) Reserves and Surplus||100000|
|2. Non-Current Liabilities|
|Long Term Borrowings||150000|
|3. Current Liabilities||50000|
|1. Non-Current Assets|
|a) Fixed Assets||400000|
|b) Non-current Investments||100000|
|2. Current Assets||200000|
Here, using the method described, the amount will be:
|Capital Employed = Fixed Assets + Non-current Investments + Current Assets – Current Liabilities|
Using the Liabilities Side of the Balance Sheet
Alternatively, we can compute the capital employed by using the liabilities side of the balance sheet. We proceed as follows:
- Include share capital (equity + preference)
- Include reserves and surplus (e.g., general reserve, capital reserve, profit & loss account, etc.).
- Include long-term borrowings like debentures and other loans.
Going back to our example balance sheet and using this approach, the formula is:
|Capital Employed = Share Capital + Reserves and Surplus + Long-Term Borrowings|
As we have read above, in the absence of a universally accepted definition, we can also use a few other approaches to compute it, e.g.,
- Sum total of all assets fixed or current (gross)
- Sum total of fixed assets (net)
Uses of Capital Employed
So, why is capital employed computed at all? Since it is a measure of resources (financial inputs) committed to a business, it assesses overall profitability (output). This is done by computing or Return on Investment (ROI).
In this formulation of ROCE, sometimes the use of average capital employed is preferred over just capital employed. What is the average capital employed? It is an average of the amount under it at the beginning and at the end of the accounting period.
Another use of it is that it is a measure of the size of the business. Regulators use it to classify businesses into small, medium, or big.